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The banks are back on top. The financials sector is the best performing sector over the past year up 39.4%, easily surpassing the 22.8% return of the S&P.

source: fidelity.com

Looking at the five industries in the financial sector, the banks rise to the top with a 46.8% return.

source: fidelity.com

Even after the big rally, the S&P 1500 financial sector still sports a pretty low forward P/E ratio of 16x versus 17.6x for the S&P 500 overall. The S&P 1500 bank industry has a slightly lower forward P/E ratio of 15.7x and a healthy dividend yield of 3.3%. Looking at only the large banks, the valuation is even lower. The S&P 500 financials has a 14x forward P/E. Sources: spindicies.com & fidelity.com

source: fidelity.com

The banks are well capitalized, and in a good position to benefit from a pickup in economic activity and lending. The lower valuation of the financial sector is in part due to the lower growth prospects versus the S&P 500. CFRA research puts the long-term growth rate of earnings in the financials sector at 8.1% vs 10.6% for the S&P 500. So the PEG ratios of the financials and the S&P are both right around 1.7x. According to CFRA, banks have historically traded at a 10% discount to the S&P 500 multiple.

The fundamentals for the sector are positive. Deposits are increasing and loan losses are historically low. Net interest margin for the industry is at a historically low level, but this may change as the Fed raises rates and allows its balance sheet to constrict.

Two ETFs in the sector which I would recommend are $XLF and $VFH. I prefer $VFH because it has a lower concentration of top holdings.